September 27, 2012

Excessive regulatory risk-aversion caused the excessively risky bank lending to the “not-risky”.

Sir, Jacques de Larosiėre writes “The crisis has shown that bank failures are not related to specific structures but to excessive risk-taking”, “Do not be seduced by the simplicity of ringfencing” September 27. We need to carefully analyze the real meaning of “excessive risk-taking”, as a lot of dangerous confusion prevails in the debate.

First, it is absolutely clear that none of current bank failures have anything to do with excessive exposures to what was perceived as “risky”. Instead all failures were related, as is ordinarily the case with bank failures, to excessive exposures to what was perceived as “not-risky”, like AAA rated securities, real estate in Spain or “infallible” sovereigns like Greece. 

What was different this time though, and what makes this crisis particularly severe, is that the banks, like never before, were authorized by regulators to leverage their equity immensely, when holding those dangerous assets perceived as “absolutely not risky”. 

And so, in this case, any excessive risk-taking of banks was caused directly by the regulators excessively wanting the banks to avoid the “risky”, and they did so, stupidly, by stimulating the banks to take excessive risky high leverages exposures to what was officially perceived as “not-risky”. 

Sadly the above has not been yet understood by those who so simplistically equate a bad result with taking an undue risk. Sometimes, quite often in fact, a bad result is due from excessively avoiding taking risks.